Your two examples are correct (as is my table), but you miss the point.
No one would judge your two examples as being equal (because of risk-adjusted return), despite the same mathematical outcome.
And volatility matters very much in practice (in any portfolio that has any cash in- or outflows, like, let’s say when you invest to FIRE, or have FIREd and withdraw regularly). Sure, mathematically, in an indefinitely untouched portfolio (that also has no risk of ever having a need to withdraw), volatility can be ignored. But then I have to throw in the DCF method: Such a portfolio, if it existed, would be worthless (assuming your purely mathematical view).
It doesn’t matter for capital that was invested at the start and is still invested at the end. It does matter if capital is withdrawn (when the risk is most visible) or added.
The fear most people have regarding sequence of return risk is that it happens while they are in their withdrawing years and the withdrawals have an outsized effect on the success of their retirement by happening at a time when the portfolio is down, leaving too few capital to compensate for it even if it goes up biggly afterwards.
@1742 I know nothing of the theories you mention. I just thought I’d point out something I noticed in your table, so you don’t base your strategy on a shaky foundation.
E.g. your Investor 4: You give the cumulative return as +33%, which I assume you arrived at via: 1.35 * 1.15 * 0.65 * 1.65 * 0.8.
But the average gain is not the sum of these percentages divided by the number of years (35+15-35+65-20)/5 = 12, but x^5=1.33 → x ~ 5.9%.
So the statement about inverse correlation does not seem to hold in my opinion.
I demand a sequence where you recover from the (4 years) 1929-1932 drawdown of 86%1 while withdrawing from your nest egg every month in the mean time. Bonus points for adjusting for inflation/deflation.
Meant in jest, of course, but as a physicist I really do admire the beauty of math, but I will staunchly stick with “you can ignore reality, but you cannot ignore the consequences of reality”.
I bet you can count the number of people who happily whistled through severe drawdowns calling their bank to sell another tranche of their very shrunk nest egg in order to finance their further life with a jolly phone call to the bank teller … on one hand. Maybe one finger.2
[1] Nominal full recovery: November 1954. Total recovery time: ~25 years.
[2] That would be you. Everyone else who still felt happy – like the Great Gatsby and maybe a Rockefeller – probably lived off their investments’ cash flows versus actually selling stuff.
Ah, I see where the issue is. You are calculating the CAGR and compare it to my listed average. And I’ll agree, it may have been clearer if I’d shown average and CAGR instead of average and cumulative to make my initial point (which still holds true).
I believe OP’s table doesn’t include any withdrawals, so I’m not sure what you want from me. I’m just pointing out something in the math of the table, which is given as the foundation of the strategy.
Yes. I guess I do not understand what the meaning of the average of the sum of the yearly percentages would represent. Or what kind of correlation could be deduced from that.
But I don’t want to derail from your actual question of how to hedge against volatiliy. So sorry for the disruption.
No worries. You just wanted to help and I appreciate that. The idea and the thread was dead anyway, it only got a second life because I recently linked to it in a newer post.
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